Risks Worth Taking

When the markets get choppy, the natural reaction is to retreat to safer investments. But the fact remains that to generate strong returns investors must be willing to tolerate some risk.

To zero in on funds that have been good bets despite having high risk scores relative to their peers, we'll use the Morningstar Risk rating. This rating is half of the Morningstar Risk-Adjusted Return measure, best known as the star rating. The Morningstar Risk rating compares the performance swings of a fund's monthly returns with other funds in its category; funds are penalized more for their downside swings than they are rewarded for outperforming their peers. (This is because investors are more sensitive to losing money than they are to earning big returns.) In each category, the 10% of funds with the lowest measured risk have "Low" risk ratings, the next 22.5% are "Below Average," the middle 35% "Average," the next 22.5% "Above Average," and the top 10% "High." We arrive at Morningstar Return in a similar way. In combination, the risk and return ratings for the three-, five-, and 10-year periods produce each fund's star rating.

To find risky funds with attractive risk/reward profiles, we'll start our search by looking for distinct portfolios that have earned Above Average or High five-year Morningstar Risk ratings. The screen was performed on Feb. 19. You can perform it in Morningstar Advisor Workstation Office Edition and Morningstar Principia.

Special Criteria = Distinct Portfolios Only
And (Morningstar Risk 5 Yr = High
Or Morningstar Risk 5 Yr = Above Average)

More than 1,500 funds met these criteria. To find funds that appear to be the best bets despite above-average risk scores, we want to screen for managers with at least 10 years at the helm and who boast top-third trailing five- and 10-year records. A strong long- term record shows that a fund has made the price of higher risk worthwhile.

And Manager Tenure (Longest) > = 10
And % Rank Cat 5 Yr < = 33
And % Rank Cat 10 Yr < = 33

We also want to limit the list to funds that are open to new investments and to those with reasonable price tags (expense ratios less than or equal to 1.25% annually).

And Purchase Constraints not = Closed-New
And Audited Expense Ratio < = 1.25

Our screen pulls 141 funds that span all five mutual fund asset classes: domestic equity, international equity, balanced, taxable fixed income, and municipal bond.

What makes this diverse group of funds similar is that each one has seen larger performance swings than has the typical fund in each category. To demonstrate, Waddell & Reed Advisor Vanguard UNVGX ranked at the top of the large-growth category for 2007 with its impressive 28% gain. However, its focus on steadily growing companies and top-heavy approach hasn't led it to do well every year. In 2001 and 2002, the fund posted annualized losses of 25% and 20%, respectively.

Franklin Federal Intermediate-Term Tax-Free Income FKITX is a muni-national intermediate fund that also has a high Morningstar Risk rating. This might seem odd given that the fund has posted top-quartile trailing returns for most periods and that it has lost money in only one calendar year (negative 1.9% in 1999). However, the Morningstar Risk rating is sensitive to all variations in a fund's returns versus its peer group-both on the upside and the downside. It appears that the Franklin Fund's performance swings on the upside versus its peer group have contributed to its high risk rating relative to its peers.

It's also important to keep absolute risk in mind. As we see with the examples above, it's not surprising that the fixed-income and balanced funds (which have combinations of equity and fixed-income holdings) have lower absolute risk compared with most of the equity funds.

For example, Eaton Vance Government Obligations EVGOX is a short government fund, and its worst three-month loss during the past 10 years has been 2.5%. To put that figure into perspective, the worst three-month loss during the same time frame from American Funds SmallCap World SMCWX, a world stock fund that focuses on small caps, is 25.2%. This reflects the fund's and its category's propensity for performance swings. In general, the most volatile funds on our list are specialty or international funds, whose returns are typically more dramatic than those of bond or balanced funds.

As always, you can revise our criteria (by including a specific Morningstar category, for example) to get a smaller number of results. Here are a few more funds that our list that Morningstar analysts recommend:

Calamos Growth A CVGRX
This large-growth fund's seasoned management team has made use of macroeconomic calls to guide their stock-picking. This can be hard to get right consistently, but the Calamos team (John Sr., Nick, and John Jr.) has gotten it right more often than not. Using top-down calls means they often cluster the fund's holdings in just a few sectors, and this ratchets up volatility. To illustrate the effect of a fairly recent theme, their outsized helping of technology stocks held the fund back in 2006. But holdings like Apple AAPL and Research in Motion RIMM drove the fund's returns to a category-topping finish in 2007. In addition to making sector bets, the managers' propensity to hold large helpings of mid-cap stocks also heightens volatility compared to the large-cap norm.

Franklin High Income FHAIX
This fund has earned an above average Morningstar Risk rating compared with other high-yield bond funds. Longtime manager Chris Molumphy and the team of credit analysts that supports him are often drawn to unloved corners of the bond market when selecting new issues for the portfolio. Going against the grain has lead to more volatility than the typical peer. One such move included staying away from CCC-rated issues (lower quality issues) while they continued their rally in 2006. This eventually paid off during the summer of 2007, as the subprime-mortgage-led credit crisis sent investors running from low-quality fare.

Oppenheimer Global Opportunities OPGIX
Portfolio manager Frank Jennings has the leeway to invest anywhere he pleases, which lands this fund squarely in the world stock category. And he's makes a lot of stock, sector, and country bets during his 10-plus years at the helm. One such bet is chipmaker Advanced Micro Devices AMD. He's held it since 2002 and made a lot of money on it up until 2006. The stock began its tumble after a price war with rival Intel started to take its toll. And while he's mostly invested the fund in stocks in recent years, he has gone into bonds and cash. These types of asset-allocation moves aren't a good fit for all investors, but over the long haul, Jennings' stock picks have made the roller-coaster ride worthwhile.

Pioneer AMT-Free Municipal PBMFX
Pioneer AMT-Free Municipal is solid, but it's not for everyone. The usually tranquil municipal-bond market was fraught with uncertainty last summer. Hedge funds flooded the muni market with bonds as they struggled to meet redemptions and margin calls, pushing bond prices down and yields up. Those funds holding higher-credit-quality portfolios weathered the storm better, as the difference in price between low- and high-quality bonds widened.

These market conditions created some wobbles in performance for this fund, which is to be expected given its approach. The fund's success hinges on manager Stephen Bauer's willingness to sacrifice the short-term stability prized by more conservative investors. For investors with a time horizon extending beyond five years, this fund is an interesting option. Yet those seeking more stability should look elsewhere.